‘The building up of the money-to-GDP ratios is both a strength and a weakness of China’s financial system.’ Discuss.

In China there has been an extensive build up in the money-to-GDP[1] ratios which has been a strength of the financial system in times of crisis but may also constitute a weakness in the long term due to effects on the quality of loans of the Chinese system and inefficiency of resource allocation.

First of all, let’s identify the money-to-GDP ratios. In the case of China there tend to be 2 main ratios discussed in the literature, namely the M1-to-GDP ratio, and the M2-to-GDP ratio. M1 is ‘narrow money’, defined as ‘currency i.e. banknotes and coins, plus overnight deposits’ (OECD, 2012) and M2 is ‘broad money’, defined as ‘currency plus demand and saving deposits’ (Naughton, 2007, p. 451).

Firstly it should be noted that cross-country analysis of the money-to-GDP ratio is limited as no international standard was implemented until the year 2000 by the IMF (OECD, 2012). Furthermore, measures of M2 in China may tend to ‘underestimate true money holdings’ due to the exclusion of some ‘deposit-like liabilities of deposit-taking institutions’ from the measurements according to Song (2007) and, according to Liang (2007), an inability to keep up with the rapid changes the capital markets in China are undergoing (Wu, 2009, p. 4). The measurement of GDP in China has also been criticised by some calling for it to be marked downwards to make up for complaints made even by Zhu Rongji, in the year 2000, of  rampant ‘falsification and exaggeration’ (Rawski, 2001). Moreover, analyses from within China often ignore or contradict official statistics (Rawski, 2001). Therefore there must be caution applied when using the ratios.

Leaving the statistical complications aside, the implications of the build up in the money-to-GDP ratio must be assessed. The build up in M2 indicates an increased monetisation in the Chinese economy. That is money is demanded more for transactions than before. To maintain growth of monetisation, the money must be absorbed without causing excessive inflationary pressures (Lodhi, 2005). M2 has grown from 32% of GDP in 1978 (Naughton, 2007) to 178% in 2009, internationally the highest (Chen, Ma, & Tang, 2011). It shows a high savings rates and the possibility of forced savings in bank deposits due to high growth coupled with few investment opportunities for residents (a high concentration of financial institutions being state-controlled banks) and a requirement to save due to a lack of strong social safety nets (Chen, Ma, & Tang, 2011). Household savings increased from 1978 as 6% of GDP to 77% of GDP in 2005 (Naughton, 2007). These bank savings are thus used for investment purposes by the government and state-owned enterprises (SOEs) with via bank lending and drive financial growth  (Chen, Ma, & Tang, 2011). This may seem a strength as it can help fuel investment. However, this growth is not necessarily as efficient as it could be and may show an inherent weakness in the system in a lack of domestic demand.

The increased monetisation may also be a weakness where inefficient loans are a systemic problem. In particular the apparent safety net of the government guaranteeing loans to banks may be a cause of inefficient investment allocation in China (Zhang, 2012). The growth in the money which came with the credit stimulus of 4 trillian yuan of the government gave excess liquidity to banks which they could not give back to the central bank (which would be a way to ‘mop-up’ excess liquidity), was trapped in the inter-bank market and therefore was lent out as credit (Zhang, 2012). The increase in loans to local governments and state-owned enterprises stimulated the government’s planned construction projects (Zhang, 2012). However, there are some warnings that, due to the lower interest rates which led to the lack of access to banks for the more efficient private sector, there is a high possibility that non-performing-loans (NPLs) will once again build up, as they did before the removal of the NPLs of the big 4 banks via asset management companies (AMCs) (Zhang, 2012) (IMF, 2011). Then again there has been a strong fall in the number of NPLs in recent years (IMF, 2011) which may be a sign of an improved lending system (i.e. better risk management, etc) through reforms, and the removal of guarantee for some SOEs which led to their bankruptcy in the 1990s, which could mean that the rise in NPLs will not be as great as it was previously. The weakness caused by the excess liquidity on China’s financial system is uncertain but the risk of further inundation of NPLs cannot be ignored. The recent influx of liquidity to the inter-bank markets will foster further the ‘addicted to investment’ (Zhang, 2012) growth pattern, which can be a problem and weakness. The problem of a lack of domestic demand and increased investment may cause ‘welfare loss for consumers, overcapacity of production, and inefficient resource allocation’ (Zhang, 2012). The long-term plan of restructuring the financial and economic system has been put off due to the (required) stimulus package of the global financial crisis according to Zhang (2012). According to some pessimists the ‘abnormally high’ M2-to-GDP ratio shows that if restructuring is not achieved and the threat of NPLs not lessened then there will be a collapse in the system and hyper-inflation (Yu, 2000). The strength of the high savings ratio as a fuel for money-to-GDP ratio increases and therefore development investment, as well as for anti-crisis stimulus packages to alleviate bottlenecks (Woo, 2003), may be seen to be counteracted by the inefficient allocation of resources and the build up of NPLs in the Chinese banks in the late 1990s. This weakness was to some extent overcome with the selling off of these debts and the lowering of banks’ NPLs and perhaps the NPL weakness is less than perceived. However, the recent stimulus package has reignited the fears of NPLs reoccurring. This may be improved by the increased financial efficiency which may be achieved through financial standardisation as outlined in the 12^th Five Year Plan (Li, 2011).

A potential strength of the financial system is its ability to be used in macroeconomic policy, through the money supply. However, there is some evidence of a ‘stop-go’ process in the Chinese states’ handling of the macroeconomic policy. By applying a tight or contractionary monetary policy (less credit made available for lending), the Chinese government would lower M1-to-GDP and therefore stifle inflation. Conversely, in the situation of deflation, a loose or expansionary policy (increasing of M1-to-GDP ratio, more credit available) would allow the government to regain price stability (Woo, 2003). When the monetary policy was applied in the 1990s while the fall in M1 caused by the tightened monetary policy did restrict inflation, the fear of a rebound of the inflation led the government to ‘overkill’ the situation and cause deflation (Woo, 2003). To get out of the situation, a policy of loose monetary policy was used and M1 shot back up, however, there was not an accompanying mass of inflation, although inflation would return. This is because excess liquidity (increased money to GDP ratio) is a cause of inflation in China (Zhang C. , 2009), but in 1997 when the reflationary policy was applied, the banks were unlikely to lend due to an unwillingness by banks to lend due to suspected retaliation for acquiring NPLs (while SOE lending was riskier than to private enterprise, an NPL from a private enterprise had negative political implications and so lending altogether dropped)  and this was not changed until bank managers were ascertained that an increase in the NPL ratio would not be blamed on them (Woo, 2003). From then until 2007 the inflation rate was kept in bounds[2] and the new reforms have led to China being able to apply a better macroeconomic strategy to effect inflation although this is somewhat limited by the exchange rate regime since the value of the currency can’t fluctuate according to macro shocks (OECD, 2010). In fact the reliance on manipulating the money supply can be seen as a weakness in its stop-go approach to causing and relieving inflation and deflation, respectively. This is backed up by the previous record of the Chinese government in the 1990s to overkill on tightened macroeconomic policy which led to deflation (Woo, 2003). The weakness of the limited macroeconomic policy of the Chinese government underpins a weakness in the financial system which is halfway through restructuring (Zhang, 2012) (Woo, 2003).

Another advantage that has occurred from the financial system and the money-to-GDP ratio has been a high rate of seigniorage (Chen, Ma, & Tang, 2011). Seigniorage is the “the supplement of real revenue accruing to authorities (government and central bank) from the monopoly they have on money supply” (Debray, 1998). Monetization and Financial Deepening (that is the increased use of financial intermediaries) both have had an effect in making a higher seigniorage possible in China’s case (Debray, 1998).  In fact how this has occurred is through the high money-to-GDP ratio without excess inflation (constantly within 20%). In general the countries which have high seigniorage are countries which experience hyper-inflation, but China has had low inflation. Furthermore, the forced savings mentioned earlier has meant that, despite facing depreciation on their saving the household saving have in general increased (Debray, 1998). In 1988-89 when there was a strong possibility of switching from accounts due to panic buying and inflation due to a perceived volatility of prices (Bramall, 2009), the indexation to inflation of interest rates on savings deposits helped prevent it (Debray, 1998). Tight monetary policy also helped overcome the inflation, though it led to deflation and a renewed loose monetary policy leading to further inflation from from 2000-2007 (Zhang C. , 2009). The effect of seigniorage depends on the M1-to-GDP ratio and here we see what it implicates for the Chinese economy. The potential revenue accrued by seigniorage by the government or central bank was relatively high while monetization was a driving force of money expansion, but between 1993-97 the potential revenue lessened (Debray, 1998). Debray accounts this to a ‘slow down of monetization’ (Debray, 1998) which will mean a fall in the revenue accumulated by money creation for the Chinese Government and/or central bank (Debray, 1998). This fall in monetisation may be contestable however, considering the further increases in M1 which have occurred, particularly if they have still occurred without inflation, which it has although the level of inflation had increased with the increased liquidity (Zhang C. , 2009). This may be a potential strength, or at least was a strength of the build up of money-to-GDP ratios.

Overall, the state-dominance of the banking sector seems to be a weakness in the financial system, and its use of the monetisation and savings for investment and policy are the main cause of difficulty in the splitting of banking system as other government revenues are small compared to many countries (Woo, 2003). The closed market has meant that the banks to not have an ‘internationally competitive business model’ and that innovation is not fully developed (Chen, Ma, & Tang, 2011). The stock market itself also is seen more as a policy market, government led, however an immature bond market has grown significantly recently, although problems still remain (Chen, Ma, & Tang, 2011).  The money markets are also greatly affected by the state-run banks whose movements strongly affect the interest rates and therefore the market cannot function without being affected by the policy biases of these banks (as shown earlier – interest rate too low for private enterprise to loan) (Chen, Ma, & Tang, 2011). However, the control of government over investment cannot always be shunned simply as inefficient. The concerns of the government for development will also hold some sway over the pattern of investment. Here the choice of the government to use increasing money-to-GDP ratios to fund investment in critical construction and infrastructure in lesser developed China may be considered a strategic long term goal for improving overall development even if returns are not perfect (Laurenceson & Chai, 2001). With growth which outstrips the original costs via increased savings due to increased incomes and thus savings, then China may be able to pay off (again) the NPLs which it accumulates from investment. Overall this shows that the monetisation may be a strength of the financial system in terms of China’s development, should policy-bias still be established.

Overall, it seems that the building up of money-to-GDP ratios has been a strength of the Chinese financial system in many ways. It has helped the government direct investment, although this has led to inefficient SOEs being financed even when they should go bust. Although this has to some extent subsided, it appears that the risk remains that NPLs will reoccur. The most dangerous problem may be that the weakness of low domestic demand is not fixed due to reliance on the savings for capital accumulation. However, should China manage to improve the social safety net it is possible that this will be overcome. The increase in money supply will become a problem when inflation it causes is extremely high, and seigniorage is lessened. Until that time it may be possible to say that the build up of money to GDP ratios is more of a strength than a weakness, particularly should reforms improve the ability of banks to lend with better risk management. Then again, there may be further strength in the government’s ability to direct investment to long-term goals with a low return which are important in its development strategy. The strength should not be overstated of monetisation however, as the increase shows growth in GDP but not growth in wealth, simply the use of money to buy and sell those things that were not bought and sold previously and thus not counted in GDP (Mu, 2007). However the effect of seigniorage must be seen as a strength. Overall it seems the strengths can outweigh the weaknesses, although with the weaknesses fixed it could be an even greater strength.

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[1] GDP = Gross Domestic Product

[2] citation